Professor Raiton’s Inside Perspectives: Entrepreneurship, Creativity, Innovation

From Startable by Healy Jones

One of the more common types of securities used by venture capitalists is the participating preferred stock. This preferred stock is an accepted part of the startup financing landscape, although it has some pretty significant impacts on the value of the common stock (i.e. the stock owned by management and employees of the startup) at an exit. In particular, participating preferred stock can significantly impact the return profile of an investment for a venture investor at a smaller exit value. Exits have shifted from IPOs, where participating preferred holders usually are forced to convert to common shares, to smaller M&A exits, where participating preferred holders have certain… special privileges. (See my recent post on VC backed exits in Q1 2009.)

Anything that provides extra return to a VC at an exit takes return from the founders, so it is important for entrepreneurs to understand participating preferred stock and its impact on the exit value of the common stock.

The one point that I would like startup CEOs to take away from this post is that:

The type of security your venture capitalist purchases will have different ramifications based on the size of your exit.

First of all,

What is participating preferred stock?

Participating preferred stock:  Preferred stock where the investor receives back their invested principal (plus any accrued dividends) before common stock holders and then participates on an as-converted basis in the returns to common stock holders. In other words, participating preferred holders get their invested dollars back THEN get their % ownership in the remaining proceeds. 

I’ll run a math example down at the bottom of the page, but here is a chart showing returns to a company that raised $3 million on a $3 million pre-money valuation.* In this chart I’ve plotted the percentage of the proceeds that go to the founders of the startup based on different exit sizes, ranging from $5 million to $1 billion. The bottom axis is the exit size; the left axis is the percent of the exit proceeds going to the founders.

Note that the founders technically own 50% of the business. However, it is pretty clear that the founders get a much lower percent of the proceeds at smaller exit values when they sell participating preferred equity to the investors. 

A smart venture capitalist will usually ask for participating preferred equity. Foley Hoag’s Emerging Enterprise Center shows that participating preferred is a very standard security in venture transactions. I do not see it as “unfair” that VCs ask for participating preferred, and they can (sort of) make smaller exits more palatable for venture investors.** 

The correct trade off for participation is valuation. In fact, a very good way to think about the participating preferred equity is to strip it into a bond component and an equity component. This will effectively derive a valuation discount in the eyes of the venture capitalist. If you as an entrepreneur want a higher valuation then you may be forced to accept a participating security. 

The point is this: if you as an entrepreneur are raising venture capital, you will need to be very realistic on the exit value you think you will achieve for the business. If you think that you are going to make it to a huge exit then the participating preferred equity will have a tiny impact on your eventual returns. However, if you think a smaller exit is likely then you should think carefully when accepting a participating security.  

*Here is the quick and way-over simplified math example:

A company raises $3 million at a $3 million pre-money valuation. Thus, 50% owned by investors and 50% owned by founders. Then the company is sold for $25 million. Returns to each group are calculated below. I’m assuming that the founders do not give any of the company up to anyone else; obviously a major simplification.

If the investor owns participating preferred

Investor: $14 million = $3 million of participation + $11 million of common stock return (50% of the common return of $22 million ($25 million exit minus the $3 million that already went to the participating preferred))

Founders: $11 million (50% of the common return of $22 million)

If the investor owns convertible preferred

Investor: $12.5 million (50% of the $25 million exit)

Founders: $12.5 million (50% of the $25 million exit)

That is a pretty big difference for both the VC and the founders. The difference, as a % basis, really increases when the exit value gets lower.

**Participation also helps VCs mirror the structure of their funds. Venture capitalists do not make carry until they have returned their limited partners’ investments. The return of capital to the venture investor (and thus to the limited partner) via the participation mechanism at an investment’s exit is a lot like this carry hurdle…

Facebook has been pitching for a new round of funding these last few months to bridge itself to an IPO sometime in the future. We’ve known that since October, when (former) CFO Gideon Yu was in Dubai. In December CEO  Mark Zuckerberg said the company was open to raising new money but only at the previous $15 billion valuation set by Microsoft.

But we’ve heard more recently that the company has been pitching hard for new cash at a much reduced valuation, hoping for at least $4 billion. And some investors are biting, but not at that price. A source with knowledge of the possible transaction tells us that  Providence Equity Partners (who are also investors in Hulu) and  General Atlantic have submitted term sheets at “around $2 billion” valuations.

Will Facebook take the expensive new money from Providence or General Atlantic? They may be forced to. They’re burning as much as $20 million a month in cash and are dealing with ridiculous growth. They likely have less than two years runway left, and possibly significantly less if they continue to add new users by the tens of millions that are currently flocking there every month.

The cost of taking money at such a low valuation is higher than it appears. In addition to the direct dilution to stockholders from the new money, old investors at the $15 billion valuation may need to be made whole. Venture rounds traditionally include anti-dilution provisions that give investors more stock if the company raises new money at a lower valuation. Those anti-dilution provisions are heavily negotiated and can end up anywhere from full protection (which is very rare) to no protection at all (which is also very rare). It’s likely that there will be some form of additional dilution, possibly a lot of it, from the  $375 million Facebook has raised at that valuation.

As an interesting side note, Providence was heavily involved in the $15 billion round, and submitted a term sheet in the $10 billion range or higher at that time. The big rumor is that Facebook convinced Microsoft that the competition was Google, not a private equity firm, and it helped close the deal at a much higher rate. If there is truth to these rumors, and we believe there is, Providence dodged a big bullet by waiting patiently for the market to come down.

From  A VC blog

Many years ago, when I was still in my 20s, the managing partner of my first venture firm, Milt Pappas, told me that he felt there were three terms that really mattered in a venture deal (other than price of course). They are:

1) The liquidation preference
 2) The right to participate pro-rata in future rounds
3) The right to a board seat

I listened intently and have been practicing what Milt preached ever since. In recent years, I’ve gotten comfortable doing a few deals without the board seat in very specific circumstances. But I’ve mostly followed Milt’s advice to me and I have been well served by it.

There are many other provisions in venture term sheets that can, at times, come in handy. There are the protective provisions, the blocking rights, the rights of first refusal and co-sale, the anti-dilution protections, redemption rights, etc, etc

I’ve seen some of these provisions invoked and they have been useful to have. But there are several typical venture terms that I have never seen invoked in almost 23 years in this business. That doesn’t mean they aren’t useful or even best practices to have them. But it does mean that some things matter more than others.

And in a negotiation, it is critical to know what you must have, what you should have, and what you can live without.

When it comes to venture terms, I believe Milt was spot on. The three things that have saved my investment and kept people honest more than any others are the three I listed up front.

The liquidation preference matters because without it, if you invest $1mm for 10pcnt of a business and the next day the entrepreneur gets an offer to sell the business for $5mm, he or she might choose to take it and get $4.5mm while you only get $500k. Sure you could negotiate for a blocking right on a sale, but getting in between an entrepreneur and an exit they want to do is not a recipe for success in the venture business It’s much better to say, “give me the option to get my investment back or my negotiated ownership, whichever is more”. And that’s what a liquidation preference is, plain and simple.

The right to purchase your pro-rata share of future rounds is possibly the most important term of all. In early stage VC, a few investments generally deliver the vast majority of the returns in a fund. When you are in one of those deals, you need to be able to invest in the subsequent rounds (to go “all in” in poker parlance). The pro-rata right is equally critical in down rounds to protect you from getting wiped out in a highly dilutive financing.

The board seat is not something all VCs care about. But you cannot have real impact on an investment without one. Its the best way to make sure the investment is going well and when it is not, the board seat gives you the right to have a say in what is needed to fix the investment.

From Altgate blog 

A while ago I wrote about how a liquidation preference works and I’ve noticed that this has quickly become one of the most popular posts on Altgate and a top-10 result in the Google search for that term.  Well, I guess it’s a sign of the time.

This week I’ve spoken with two startup CEO friends who have raised inside rounds and got clobbered with a 3x participating liquidation preference.  I called up a couple of attorney friends and a couple of VCs to see if this was in fact becoming “normal” and everyone said “ya, pretty much.”  From what I can tell the increase in the cost of capital for startups is partly to do with projections being revised down, but also (maybe even more so) because of a big mismatch in supply and demand for capital.  Even companies that have countercyclical businesses are finding cash more expensive.

Let’s recap how expensive a 3x liquidation preference really is.  Say you raise $8MM at $17MM pre-money ($25MM post) with a 3x participating preferred.  Further assume that that money lasts you 2 years until you sell the company for $50MM to Microogle which would certainly be a “happy” ending all things considered.  In that scenario your last round investors will get $24MM of that sale off the top (3x their $8MM investment).  Then your other preferred investors will get their preference (let’s assume they have $12MM at 1x invested in two rounds at a $17MM post-money valuation which would make the “current” round flat).  When you throw in the $5MM of dividends that have accrued on the preferred, then Common shareholders will get approximately ZERO from this sale for $50MM.  If the sale price goes up to $75MM, Common gets to split about $5MM in proceeds.  Yippee.

In reality, what happens is the board will negotiate a carve out for then-current management if an opportunity to sell comes along or a refresh if an exit is still far off.  But non-management employees and founders will be thrown table scraps and crushed down.  You could probably find some pawn shops that offer cash more cheaply.

What’s the alternative?  The only potential alternative is crazy cuts to your expenses that allow you to survive.  What’s crazy?  Could be you need to consider cutting back to just a couple people and then reboot to have any hope of retaining founder economics. 

From Get Venture by Mark Davis

One of my mentors once said, VCs love to be the first to be second. They don’t want to be the first to issue a term sheet, but will issue one quickly once someone else has.

As a result, VCs often make their term sheets exploding offers – they expire within a defined timeframe. This enables them to reduce the odds that other VCs will be able to make competitive bids to invest in the startup before the entrepreneur has to make a decision.

If you like the VC you’re working with and the terms are fair, this isn’t an issue. However, this dynamic is something that you should be aware of, as you will need to be prepared to quickly review the terms of the term sheet.

The good news is that term sheets typically aren’t issued out of the blue – if you watch for the signs that you are close to receiving a term sheet, you can be prepared to respond to exploding offers.

Get Venture by Mark Peter Davis

There are two points in the investment process when VCs typically issue term sheets: before due diligence or before confirmatory due diligence.

VC funds that issue term sheets before the due diligence process typically do a deep dive into their external diligence on the company after the term sheet is issued. The external research that I am referring to here includes, market evaluation, a review of the competitive landscape, customer calls and a testing of other unique considerations (e.g., regulatory reform).

However, VCs that issue term sheets after they complete (or nearly complete) their external due diligence still conduct confirmatory due diligence after the term sheet is issued. Confirmatory due diligence might include management reference calls and a review of the company’s actual financials, patents and contracts. Confirmatory due diligence is by-in-large a review of the claims management made which are likely to be less subjective in nature.

While exceptions exist, most funds are consistent about issuing their term sheets at the same point in the process. Each fund either typically issues term sheets before any due diligence or after the external due diligence but before the confirmatory due diligence.

From Startup Company Lawyer by Yokum

[This is the first of a series of posts on down round and dilutive financings.]

I don’t want to add to the “sky is falling” in Silicon Valley theme that I’ve read on various blogs, but given recent economic conditions, a review of how venture financing deal terms may change seems warranted.

Existing investors generally want new investors to set valuations and deal terms in subsequent rounds of financing for a company. However, these deal terms typically become more investor favorable as raising money becomes more difficult. In many cases, existing investors are left to fund the company as new investors are unwilling to invest.

Unlike conventional, “up-round” financings which have a fairly predictable range of terms, the structures and terms of down round financings are variable.  A “down round” financing typically occurs when a company issues securities to investors at a purchase price less than that paid by prior investors.  Absent anti-dilution protection, a down round financing will dilute both the economic and voting interests of the prior stockholders.  A “washout” or highly dilutive financing, is an extreme form of down round financing that significantly reduces the percentage ownership of prior stockholders.

Below are some features of down round and highly dilutive financings.

(Read More)

From Get Venture by Mark Davis

When a VC sends you a term sheet it will typically include a clause about the operating founder’s equity vesting over time.  This means that the founders of the company will not have rights to some or all of their equity stakes until they earn it by working with the company for a period of time.

This seems backward to some new entrepreneurs.  How can they lose the rights to something that they already own?  There is, however, good reason for the vesting clause.

When an investor backs a company, he is betting on the management team as much (if not more) than the idea or technology.  Ideas and technologies don’t become companies on their own – entrepreneurs make that happen.  Imagine a scenario in which, shortly after a VC invests several million dollars, the management team quits knowing that they have an equity stake in the company.  The investors would be left to pull together a new team and face losing their investment.

The objective of this clause isn’t to cheat the founders out of their equity. Remember, the good VCs want key operators to have sufficient equity. Rather, the clause is designed to ensure that the founding team has an incentive to stick around and build the company – putting forth the effort that was promised to the investor.

From Get Venture by Mark Davis

 Option pools are common shares that are set aside to compensate and incentivize future employees of the company.  The most sophisticated entrepreneurs create option pools before seeking investment from VCs.  However whether or not you have created an option pool before seeking investment, the cap table proposed by a VC will include an option pool.

Option pools are created at or before the time of investment for a few reasons:

• First, option pools ensure that the company has sufficient shares to compensate new hires, avoiding any future politicking of stakeholders to protect their investments at the expense of the company’s growth.
• Second, creating new shares in the future can be costly (legal and accounting fees) and time consuming (as the board is required to meet and approve the creation of new shares).
• Third, by allocating the option pool up front, it is easier for the VC to evaluate the dilutive effect that these shares might have on stakeholders, enabling VCs to ensure that the cap table is appropriately balanced for the near future.

Depending on how many employees the company needs to hire in the future, their seniority in the company and the value of the company, the size of the option pool may vary.  However, at the series A round the option pool is typically sized as 10% to 20% of the cap table.

Options pools are a standard component of the cap table – something that entrepreneurs should be aware of when considering the future structuring of the company.